Economics: Demand and Supply Applications

The market system or price system performs two important and closely related functions:
1. Price Rationing - the process by which the market system allocates goods and services to
consumers when quantity demanded exceeds quantity supplied
- means that whenever there is a need to ration a good - that is, when a shortage
exists - in a free market, the price of the good will rise until quality supplied equally quantity demanded
- that is, until the market clears
2. Allocation of Resources

= As the price rises, the available supply is rationed.

= The idea of willingness to pay is central to the distribution of available supply, and willingness
depends on both desire (preferences) and income/wealth. Willingness to pay does not necessarily
mean that only the very rich will continue to buy the product when the price increases. For anyone to
continue buy the product at a higher price, his or her enjoyment comes at a higher cost in terms of
other goods and services.

Demand-Determined - this happens when a product is in strict scarce supply; its price is determined
sold and exclusively by the amount that the highest bidder or highest bidders are willing to pay

Fairness - policies designed to stop price rationing are commonly justified in a number of ways, and
this is the rationale most often used

= Although it is not precisely true that price rationing allocate goods and services solely on the basis of
income and wealth, income and wealth do constrain our wants.

Various scenes to keep price from rising to equilibrium are based on several perceptions of injustice:
1. Price-gouging is bad
2. Income is unfairly distributed
3. Some items are necessities and everyone should be able to buy them at a reasonably price

Price Ceiling - is a maximum price that sellers may charge for a good, usually set by government

= At the restricted price, quantity demanded remained greater than quantity supplied.

Nonprice Rationing Systems:

1. Queuing - waiting in line as a means of distributing goods and services
2. Favored Customers - those who receive special treatment from dealers during situations of excess
demand
3. Ration Coupons - tickets or coupons that entitle individuals to purchase a certain amount of a
given product per month
4. Black Market - a market in which illegal trading takes place at market-determined prices

= When ration coupons are used with no prohibition against trading them, however, the result is
almost identical to a system of price rationing. Those who are willing and able to pay the most buy up
the coupons and use them to purchase. The price of the restricted good will effectively rise to the
market-clearing price.

Price Floor - is a minimum price below which exchange is not permitted

= If a price floor is set above the equilibrium price, the result will be excess supply; quantity supplied
will be greater than quantity demanded.

Minimum Wage - a price floor set for the price of labor

Consumer Surplus - is the difference between maximum amount a person is willing to pay for a good
and its current market price

= The supply curve in a market shows the amount that firms willingly produce and supply to the market
at various prices. Presumably it is because the price is sufficient to cover the costs or the opportunity
costs of the production and give producers enough profit to keep them in business.
Cost of Production - this is everything that a producer must give up in order to produce a good

Producer Surplus - is the difference between the current market price and the full cost of production
for the firm

Deadweight Loss - is the total loss of producer and consumer surplus from underproduction or
overproduction

Perfectly Competitive Markets - prices are determined by the free interaction of supply and demand

= When supply and demand interact freely, competitive markets produce what people want at the least
cost, that is, they are efficient.

Monopoly Power - gives firms the incentive to underproduce and overprice

Summary

THE PRICE SYSTEM: RATIONING AND ALLOCATING RESOURCES

1. In a market economy, the market system (or price system) serves two functions. It determines the
allocation of resources among producers and the final mix of outputs. It also distributes goods and
services on the basis of willingness and ability to pay. In this sense, it serves as a price rationing
device.

2. Governments as well as private firms sometimes decide not to use the market system to ration an
item for which there is excess demand. Examples of nonprice rationing systems include queuing,
favored customers, and ration coupons. The most common rationale for such policies is fairness.

3. Attempts to bypass the market and use alternative nonprice rationing devices are more difficult
and costly than it would seem at first glance. Schemes that open up opportunities for favored
customers, black markets, and side payments often end up less fair than the
free market.

SUPPLY AND DEMAND ANALYSIS: AN OIL IMPORT FEE

4. The basic logic of supply and demand is a powerful tool for analysis. For example, supply and
demand analysis shows that an oil import tax will reduce quantity of oil demanded, increase
domestic production, and generate revenues for the government.

SUPPLY AND DEMAND AND MARKET EFFICIENCY

5. Supply and demand curves can also be used to illustrate the idea of market efficiency, an
important aspect of normative economics.

6. Consumer surplus is the difference between the maximum amount a person is willing to pay for a
good and the current market price.

7. Producer surplus is the difference between the current market price and the full cost of production
for the firm.

8. At free market equilibrium with competitive markets, the sum of consumer surplus and producer
surplus is maximized.

9. The total loss of producer and consumer surplus from underproduction or overproduction is
referred to as a deadweight loss.